1. Field of the Invention
The invention relates generally to financial services, and in particular, to the management and distribution of investment funds and separate accounts.
2. Background Art
In 1993, The American Stock Exchange (“AMEX”) created the first ETF in the United States, SPDR (“SPY”), Standard & Poor's Depositary Receipts which represent ownership in the SPDR Trust Series 1, a unit investment trust holding the stocks in the Standard & Poor's 500 Composite Stock Price Index. Two other well known examples of ETFs also structured as unit investment trusts are: (i) Diamonds (“DIA”), Diamonds Trust Series 1 holding the equity securities included in the Dow Jones Industrial Average, and (ii) the Nasdaq 100 Index Tracking Stock (“QQQQ”) which represents ownership in the Nasdaq 100 Trust holding the equity securities included in the Nasdaq 100 Index. Most other ETFs are organized as management investment companies with a structure and governance mechanism patterned after traditional mutual funds. All ETFs currently traded in the United States are designed and intended to provide investment results that, before expenses, generally correspond to the price and dividend yield performance of their respective index.
ETFs were originally established for investors to trade and hold diversified portfolios of marketable securities (stocks and/or fixed income securities) generally structured to correspond to a specific market index covering broad or narrow segments of a stock or bond market. Approximately 150 indexed ETFs were traded in the United States at the end of 2004.
Unlike open-end mutual funds and like all publicly traded stocks, ETF shares are structured to trade intra-day with the ease and liquidity of a share of stock, giving investors ownership of a portfolio through one security and the ability to purchase fund shares on margin and to sell them short. Currently available ETFs are generally low-cost funds because they are based on an index, and are not charged active management fees. The Securities and Exchange Commission (“SEC”) has not yet allowed ETFs to be “actively managed,” but has issued a Concept Release (SEC Release No. 1C-25258, Nov. 8, 2001, Actively-Managed Exchange-Traded Funds) and otherwise indicated a willingness to consider applications to issue such funds.
Pursuant to SEC exemptive orders, the currently available ETFs do not sell individual fund shares directly to investors as mutual funds do. In the generalized ETF creation and redemption process as described herein, ETFs issue and redeem their shares only in blocks (50,000 fund shares in the case of the SPY, for example) that are known as “Creation Units.” The creation and redemption of ETF shares is done primarily by authorized participants (broker-dealers that have executed agreements with a fund's agents to create and redeem fund shares). Although a few funds authorize all cash creations and/or redemptions, authorized participants generally do not purchase or redeem Creation Units entirely for cash, but rather buy or sell Creation Units by delivering or receiving a basket of securities (plus or minus cash) that generally mirrors the portfolio of the ETF in a transaction facilitated by the fund's custodian and/or transfer agent. The authorized participants who purchase and redeem ETF Creation Units are predominantly market makers in the fund shares. After purchasing a Creation Unit, the authorized participant often splits it up and sells the individual shares on the secondary market, permitting other investors to trade in lots as small as an individual share.
Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell Creation Units back to the ETF. ETFs generally redeem Creation Units in-kind by giving investors securities from the fund portfolio instead of cash. For example, the DIA ETF invested in the stocks in the Dow Jones Industrial Average (DJIA) would pay a redeeming shareholder by delivering some or all of the securities that constitute the DJIA. At its discretion, the fund may substitute cash for some or all of the securities in a creation or redemption transaction. To prevent investor confusion and because the redeemability of ETF shares is limited to Creation Units, ETFs may not call themselves mutual funds.
Mutual funds and ETFs are regulated primarily under the Investment Company Act of 1940, but are also subject to significant regulation under the Securities Act of 1933 and the Securities Exchange Act of 1934.
Unlike the ETFs available today, mutual funds are frequently actively managed. Like ETFs, mutual funds pool capital from many investors and invest in stocks, bonds, short-term money-market instruments, and other securities. Traditional and distinguishing characteristics of mutual funds are: (i) mutual fund shares are purchased by investors for cash, directly or through a broker or other intermediary, from the fund itself, rather than from other investors or market makers on a secondary market; (ii) the purchase price that investors pay for mutual fund shares is often the fund's per share net asset value (NAV); (iii) shareholder fees that the fund imposes at purchase (such as sales loads) may or may not be charged; (iv) mutual fund shares are usually redeemed at NAV for cash by the fund at the time of sale by the investor rather than being sold through and into the secondary market; (v) mutual funds generally sell and redeem their shares daily without limit, although some funds will stop selling new shares when they become large; and (vi) mutual fund operations and portfolios typically are managed by management companies known as investment advisers that are registered with the SEC.
Investment advisers receive management fees for managing the portfolio and operating the mutual fund. Some funds may also have sales charges or loads imposed in connection with a fund share sale or redemption or charges for distribution and service costs, commonly levied as 12b-1 fees, may be collected annually by the fund manager. Additionally, a mutual fund may offer different classes of shares with each class having different fees and expenses.
Early in September 2003, New York State's attorney general, Eliot Spitzer, announced a $40 million settlement with a hedge fund that had allegedly engaged in “late trading” and “market timing” with mutual funds. Late trading allegedly involved the hedge fund being permitted to buy and sell fund shares at the fund's 4:00 p.m. net asset value (NAV) several hours after the prices used in the NAV calculation were determined—a violation of U.S. SEC Rule 22c-1. Distinct from the transactions at “backward” prices were a number of market-timing trades initiated at or slightly before 4:00 p.m. In some cases, these trades may have taken advantage of “stale” prices in foreign or illiquid markets. In many cases, the market-timing trades created a need for the fund to trade during the following day's trading session. Any market impact cost of the next-day trades was borne by all the fund's shareholders.
There is strong evidence, apart from the recent publicity, that fund share orders coming to a fund late in the day is a common practice. These orders come from investors with motives far more diverse than market timing over a few days.
Since the Spitzer settlement called attention to these practices, the emphasis of most regulators and pundits has been on developing regulations to prevent improper trades based on stale prices or executed in violation of prospectus prohibitions against market timing. The problem with adding new regulations is that the abuses cited are possible only because the standard mutual fund pricing and trading processes are inherently flawed.
Most fund share trades that arrive late in the day are costly to existing fund shareholders no matter whether they were initiated by short-term traders or by ordinary investors. The cost to shareholders of fund orders entered at or just before the market close has been estimated as high as $40 billion a year. Orders the fund does not receive by early afternoon cost fund shareholders much more than simply the profits that some traders take away.
Last-minute fund buy orders frequently arrive on days when the market is strong near the close. Because orders to be executed at the market-on-close must be entered earlier, investors cannot buy the separate stock positions held by a typical equity fund at 4:00 p.m. closing prices by entering stock buy orders at 3:59 p.m: The investor can, however, buy shares in most funds a few seconds before 4:00 p.m. Just as an investor cannot execute stock trades at closing prices right before the NAV calculation, the fund cannot make an immediate trade for its portfolio at closing prices to invest the new cash. Whether they intend to get in and out quickly or to stay for years, many buyers of fund shares make last-minute purchases on days with a strong market at the close. If these buyers capture market momentum, their trades are particularly costly to their fellow fund shareholders because the fund will have to buy stocks at even higher prices on the next trading day to invest the cash inflow. Correspondingly, if a shareholder redeems fund shares with an order entered near 4:00 p.m., the fund will have to sell portfolio securities the next trading day, often at lower prices, to cover the redemption. The fund is thus providing free liquidity to these investors, and the fund's shareholders pay the cost of that liquidity. The cost of providing this liquidity is a permanent drag on the performance of the fund. It does not go away, even if the investor stays in the fund for many years. The net effect of the limited regulatory changes proposed in the wake of the scandals is to slightly reduce the nominal level of shareholder protection from the cost of late afternoon orders, offering false comfort to investors.
Studies of the impact of fund share trading offer compelling evidence that the costs to ongoing (non-trading) shareholders of providing free liquidity to trading shareholders are substantial. Roger M. Edelen (1999), then a professor at the Wharton School at the University of Pennsylvania, quantified the adverse effect of shareholder entry and exit costs on fund performance. Using a sample of 166 conventional (no-load) mutual funds ranging in type from small-capitalization to income funds, Edelen examined all purchases and sales of securities by the funds over a series of six-month periods. The six-month interval was determined by the reporting interval for mutual funds at the time of the study. Edelen broke down each fund's trading into flow (fund share turnover) and non-flow (portfolio composition changes) components. He measured how much of the flow-related trading was incremental trading resulting from the need to purchase and sell portfolio securities in response to the entry and exit of shareholders. His methodology revealed the cost of this trading, not the motives of the buying and selling shareholders. Edelen did not attribute a performance cost to flow trading if the manager was able to use the flow to make desired portfolio changes. He concluded that for the average fund in his sample, 30 percent of the flow into and out of the fund did not result in incremental trading and about half of the fund's total trading was flow related.
If 70 percent of flow resulted in incremental trading, then about 35 percent of total fund trading was incremental trading that resulted from providing liquidity to entering and leaving shareholders. The average fund Edelen studied was clearly not used aggressively by fund traders; aggressive trade timing can easily cause a rate of annual fund share turnover of several hundred percent. The modest flow and fund share turnover in Edelen's sample notwithstanding, the trading costs he attributed to the liquidity offered to entering and exiting shareholders accounted for an average net reduction in annual investor return of about 1.43 percent.
The 1.43 percent cost of providing liquidity to buyers and sellers of fund shares easily justifies a $40 billion annual minimum estimated performance cost of late-afternoon fund share orders. Recent figures show assets in U.S. stock and hybrid funds at about $4 trillion. Applying a conservative cost of providing liquidity of just 1 percent annually produces a $40 billion estimate of the cost/performance penalty that this feature of mutual funds costs the funds' shareholders.
Another problem with existing funds is the fact that most sizeable investment-management organizations offer a wide variety of products to investors. These investment products are theoretically managed independently because each portfolio is independent in composition. However, funds and other products with the same advisor are often managed under a common investment process and hold numerous securities in common. Furthermore, the investment manager has a responsibility to the beneficial holders of each portfolio or “separately managed” product to treat them fairly, when management of the products is partly integrated. Thus, when the firm embarks upon the purchase of a particular security or group of securities, the securities are often purchased for many or maybe even all of the manager's accounts or funds at about the same time. To manage conflicts of interest, many investment management organizations have developed techniques to handle purchases and sales for different accounts in a random sequence or rotation. The rotation is designed to assure that a particular account or group of accounts comes first on the list for some investment changes, in the middle for others and, inevitably, at the bottom of the list for still others. If the investment management organization has a trading desk that handles trades for all of the manager's accounts, the desk may calculate an average price and give each account the same average price with all accounts participating in trades over a longer period. The problem with these procedures is that each type of account that might hold a specific position has characteristics that cause its trading practices to reveal different amounts and kinds of information, almost at random, to other market participants while the trading moves through account categories or trades are allocated to all accounts over a period of a few weeks. An investment manager that manages only funds registered under the Investment Company Act of 1940 can preserve the value of investment information better than a manager that has a diverse product line.
Mediocre performance by most mutual funds has been attributed in part to a fund management incentive structure that encourages funds to accept all assets offered to them by potential shareholders. A management process capable of delivering superior performance for a small fund is often swamped with assets after a brief period of good performance. The manager makes more with a larger asset base, but shareholder performance is diluted by asset growth. Both shareholders and fund managers might benefit from a fund structure that caps asset growth and pays higher fees for managers that deliver superior results.
Although mutual funds are used by many investors including individuals, institutions, endowment funds, qualified retirement plans and others, mutual funds and their typical investment process are not generally designed to: (i) offer investors inherent protection from most of the abuses uncovered in the recent mutual fund trading scandals; (ii) minimize investor costs from fund share and portfolio turnover; (iii) require an efficient investment management process at the management company responsible for the selection of investments for a fund; (iv) provide an appropriate allocation of transaction costs between entering and leaving shareholders on the one hand and ongoing shareholders on the other hand; (v) allocate marketing and service costs appropriately among various groups or classes of fund shareholders; or (vi) protect the confidentiality of an investment manager's trading plans when the fund or funds are managed as part of a multi-product integrated investment process.
An investment manager can provide effective portfolio management to diverse investors most economically by using a common investment process for a variety of accounts. In practice, however, the integrity of the investment process is often compromised by managing some assets in a fund where position disclosure is deferred and other assets in separate accounts where positions and position changes may be disclosed at or before the time trades occur. Current securities laws and regulations in the United States can make it difficult or inefficient for an investment manager to offer a common investment process to investors that have similar investment objectives, but are accustomed to paying different investment management fees and expenses. Overcoming these obstacles and use of a common investment process for different types of investors has economic value and performance advantages for an investment manager and its clients, including mutual funds, exchange-traded funds, unit trusts, closed-end funds and investors with interests in a variety of types of separate accounts.
Investment managers frequently offer similar portfolios to their clients through diverse vehicles such as investment companies, including mutual funds, exchange-traded funds (such as those described above), unit trusts, closed-end funds and separate accounts. The separate accounts may include pooled and non-pooled accounts offered by insurance companies and banks and non-pooled accounts offered by brokerage firms and other financial intermediaries. Unfortunately, serving diverse clients within a single investment process often leads to inappropriate revelations of trading plans, and such revelations may be detrimental to performance achieved for all clients of the investment manager. Record-keeping and maintaining both trading confidentiality and fair trade allocation for numerous similar accounts with separate portfolios is often costly and complex using current techniques.
Separate accounts may also include relatively large customized accounts for a single client and pooled accounts serving institutional and individual investors directly or embedded in variable annuities or variable life insurance contracts. Further, the separate accounts may include what are known as separately managed accounts (SMAs) that are offered by investment managers, often through an intermediary such as a brokerage firm, to individual investors. SMAs are not generally pooled accounts. Each SMA typically has a single owner or joint ownership by two or more members of a family. The suitability of each of the separate account variations for integration in a common investment process with funds and with other separate accounts depends on the confidentiality of its portfolio management and trade execution processes. Some separate account variations do not meet appropriate confidentiality standards for integration with other accounts in a common investment process.
There is, therefore, a need for methods, systems, and computer program products that bring all investors into efficient accounts while preserving the integrity of the investment process, that treat all investors equitably in the execution of transactions to change portfolio composition, and that protect ongoing investors from transaction costs incurred to accommodate entering and leaving investors. Further, there is a need to improve confidentiality and fairness of trade execution and allocation, while simultaneously reducing expenses and providing improved investor protection from transaction costs incurred in accommodating clients that bring assets into or remove assets from the manager's investment process.